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Posted 5/3/2001






























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The Speculator
Make volatility and uncertainty your friend
The variables of investing have an indicator: the VIX. Buy when it's high, sell when it's low and our charts say you'll make money.
By Victor Niederhoffer and Laurel Kenner

When fortune means to men most good she looks upon them with a threatening eye.
-- William Shakespeare, "King John," Act 3, Scene 4

Swings in optimism are one of the most notable regularities in market moves. Even a cursory examination shows that key sentiment indicators -- the percentage of bullish advisers, the percentage of advancing stocks, the degree of bullishness and risk in options, and the percentage of cash held by mutual funds -- swing back and forth from high to low like pendulums.

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The big question is whether these changes in sentiment have any predictive power vis-à-vis future moves in the general market or individual stocks.

We chose to test this concept by focusing on the predictive properties of the Chicago Board Options Exchange's Volatility Index, or VIX ($VIX.X). This is the average of implied volatilities of short term, at-the-money index options traded at the CBOE. VIX shows the level of variability that the market would have to demonstrate over the next month to make current option prices fair.

We previously reported some results on this measure in December ("Turn a profit when the sky is falling "), when the VIX was unusually high and we were bullish. We will now update these results and report on an elegant, useful and rigorous study by David Simon and Roy A. Wiggins III, "S&P Futures Returns and Contrary Sentiment Indicators," that appears this year in the Journal of Futures Markets.

The normal range for the VIX over the past five years has been 20% to 25%. In general, readings above 30% are considered relatively high and readings under 20% are relatively low. As we write on Wednesday, it stands at 27.5%, down from an inordinately high level of 32.5% just a week ago.

The basic theory
A good working hypothesis is that when the VIX is high, sentiment is unusually pessimistic and it's a good time to buy stocks. Conversely, when the VIX is below 25% or 20%, sentiment is unusually optimistic and it's a good time to sell.




So here's the concept in a nutshell: It's highly profitable to buy financial instruments that mimic the movement of the S&P 500 Index ($INX) the first time the VIX closes above 30%. And you would sell the first time the VIX closes below 25%. Appropriate instruments would include S&P futures contracts, the Vanguard 500 Trust (VFINX) mutual fund or SPDRS Trust (SPY, news, msgs) shares, referred to by traders as "spiders."

The table below shows that swinging from buy to sell with a system like this yields an average profit of 3.1% on 11 trades in securities mimicking the S&P 500 since October 1997. There were just two small losses among the 11. And the system appears to work fairly well for General Electric (GE, news, msgs), where the average profit has been 5.1%.


VIX Swing System
S&P 500 GE Intel
Date VIX Buy Sell Chg Buy Sell Chg Buy Sell Chg # of Days
10/27/1997 39.96 876.99   20.64   18.69  
12/1/1997 24.88 974.77 11.1% 24.67 19.5% 20.38 9.0% 35
12/24/1997 30.47 932.70   23.69   17.56  
12/30/1997 24.93 970.84 4.1% 24.79 4.6% 17.92 2.1% 6
1/9/1998 34.46 927.69   24.14   17.97  
1/14/1998 24.21 927.94 0.0% 24.79 2.7% 18.86 5.0% 5
8/4/1998 33.10 1,072.12   28.48   20.48  
11/5/1998 24.80 1,133.85 5.8% 30.27 6.3% 23.50 14.7% 93
12/14/1998 32.47 1,141.20   28.89   27.89  
12/18/1998 24.66 1,188.03 4.1% 32.33 11.9% 30.00 7.6% 4
1/13/1999 31.26 1,234.40   32.19   34.75  
3/8/1999 24.98 1,282.73 3.9% 34.94 8.5% 29.91 -13.9% 54
9/23/1999 30.28 1,280.41   38.92   38.75  
10/6/1999 23.53 1,325.40 3.5% 41.23 5.9% 38.47 -0.7% 13
10/15/1999 31.48 1,247.41   38.54   35.44  
10/21/1999 24.77 1,283.61 2.9% 41.14 6.7% 35.84 1.1% 6
4/5/2000 30.59 1,487.37   51.06   64.94  
6/1/2000 24.74 1,448.81 -2.6% 52.25 2.3% 64.84 -0.2% 57
10/11/2000 30.95 1,364.59   56.56   35.38  
1/23/2001 23.86 1,360.00 -0.3% 46.68 -17.5% 35.38 0.0% 104
2/28/2001 31.00 1,239.00   46.50   28.56  
5/1/2001 1,258.00 1.5% 48.76 4.9% 30.91 8.2% 62
     
Averages       3.1%     5.1%     3.0% 37.7


How would one use such a system without buying a market index specifically? When the VIX is above 30%, an investor might wish to become aggressively bullish in volatile stocks or indexes of his or her choosing. During the remaining time-about three-quarters of the days in the past four years -- the investor might wish to become cautious, to the point of staying out of the market.

Simon and Wiggins came to similar conclusions with a separate approach. They looked at the effect on the S&P 500 futures of each percentage point change in the VIX. They concluded that for each percentage point increase in the VIX above its norm, the S&P goes up an extra 0.1% in the next 10 days, compared to normal. Thus if the VIX goes up 10 percentage points to 35% from its norm of approximately 25%, the S&P 500 Index can be expected to go up 1% extra in the next 10 days. Conversely, when the VIX falls 10 percentage points to 15%, the S&P can be expected to fall 1% relative to its normal move.

Simon and Wiggins also show what happens when the VIX is at high levels and at low levels. Most impressive of all, they run what is called an "out of sample test." They demonstrate that with information available to a forecaster at the beginning of each year, a useful forecast could be made. For example, on a prospective basis they came up with 39 forecasts that the S&P futures would go up in the next 10 days. In actuality, 22 of them went up and the average change was exactly as predicted: up 1%. Similar results occur for the occasions when the market was predicted to go up by 3%.

The professors are not the usual run of academics who obscure their results with impenetrable mathematical and statistical gyrations so that the results only become meaningful to a handful of fellow travelers, and reproducible by none.










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 Perhaps the reason is that Simon, who teaches at Bentley College in Waltham, Mass., has an unusual background for a professor. He actually worked for a hedge fund before going to academia, rather than the much more common reverse situation. The professor is not averse to a bit of trading of his own and is active in individual stock options. Furthermore, Bentley has a trading floor for its students with dozens of workstations and live feeds from all the major data providers that would make most traders green with envy. And the students actually use these machines to answer realistic trading questions that they are assigned in class.

Where we stand
At present, the VIX is exactly in the middle of the bearish and bullish range at 27.5. It is coming off a buy signal on Feb. 23, when it closed just above 30%. Sentiment among investors is decidedly upbeat at present, with the S&P 500 closing at a level not seen since the start of March.

All things considered, the degree of optimism is too high for us, since it borders on the kind of exuberance that has led to agonizing recriminations in the recent past.

Because we write weekly, it is hard for us to fine-tune our predictions. But to the extent that any of you have followed the repeated bullish forecasts that we gave when the market sentiment was quite pessimistic and stocks were regularly setting new lows, we would suggest taking your fortune and converting it to cash equivalents until fortune once again becomes threatening.

At the time of publication, Laurel Kenner and Victor Niederhoffer did not own shares in any of the equities mentioned in this column.





MSN Money's editorial goal is to provide a forum for personal finance and investment ideas. Our articles, columns, message board posts and other features should not be construed as investment advice, nor does their appearance imply an endorsement by Microsoft of any specific security or trading strategy. An investor's best course of action must be based on individual circumstances.